Financial Learning Center
- What Initiates a Distribution?
- Five Dates You Should Know
- Selecting a Distribution Option
- Deciding on a Payout Option
- Annuity Form of Payout
- Advantages and Disadvantages of Taking an Annuity
- Taking a Lump-Sum Distribution: Know Your Options
- Annuity vs. Managing Your Own Retirement Assets
- Advantages and Disadvantages of a Lump-Sum Distribution
- The Roth IRA–How Does It Fit In?
- Making the Decision: Annuity or Lump-Sum?
- Taxation of Distribution Options
- Rollover into a Traditional IRA
- Advantages and Disadvantages of Rollover to a Traditional IRA
- Annuity Payouts
- Early Distributions
- Should You Defer Your Retirement Plan Distribution as Long as Possible?
- Distributions Following Death
The lump-sum payment option is the typical form of payout for most defined contribution plans such as profit-sharing plans or 401(k) plans. Many defined benefit pension plans also provide for a lump-sum payment option. A lump-sum distribution is an amount of money you can take as income (on which you will pay taxes), or roll over to a traditional IRA within 60 days or to another eligible plan. If your defined benefit pension plan allows you to take a lump-sum distribution, the amount you receive represents the present value of all future benefits. If you elect to receive a full lump-sum, neither you nor your beneficiary will receive any further payments from your employer's pension plan after receiving the lump-sum distribution. Lump-sum distributions require careful thought and treatment.
When it comes time to take your money as a lump-sum from your company's retirement plan, you'll have a choice to roll it over into a traditional IRA within 60 days or keep it and pay income tax on the taxable portion.
Paying Current Tax on Your Lump-Sum Payment
At retirement, you typically have the following options on how to withdraw your qualified employer retirement plan money:
- Pay tax on a lump-sum distribution in the year of receipt and invest the balance to generate a monthly annuity or make withdrawals only as needed.
- Roll over the lump-sum distribution to a traditional IRA within 60 days and receive a monthly annuity, withdraw as needed, or convert it to a Roth IRA.
- Elect to receive a monthly annuity from your employer.
- Leave the money with your current employer, and withdraw as needed, or wait until age 70½ to begin minimum distributions.
Let's first compare Choices 1 and 2; that is, receiving a lump-sum distribution and paying the tax currently due versus deferring taxation of the lump-sum distribution by rolling over the proceeds to a traditional IRA. In both cases, withdrawals will be made after a specified period.
Facts: Your lump-sum amount is $200,000; pre-tax interest rate of 6%; after-tax interest rate of 4.32%, and a marginal income tax rate of 28%. The example assumes no capital gain portion, and that minimum distribution rules have not taken effect.
Choice 1: Receive a lump-sum distribution and pay tax currently. Reinvest the money and make no withdrawals until the end of the specified period.
Choice 2: Roll over the lump-sum distribution to a traditional IRA and then tax the balance as ordinary income upon distribution at the end of the specified period.
Following is the after-tax cash you would have available after 5, 10, and 15 years:
IRA rollover taxed as ordinary income
Based on the above analysis, for a five-year period there is no advantage to paying the tax currently. The advantage of the assets growing in an IRA in a tax-deferred environment outweighs taking a lump sum distribution and paying the taxes. So if your intention is to invest your money for growth, the better choice is to keep the assets in a tax deferred account. Options 2, 3 and 4 in most cases are preferable to taking a lump sum and paying taxes in the distribution year. Options 2, 3, and 4 allow the money to grow tax deferred as long as possible.
Two other factors as to why you may not want to take a lump sum distribution are:
- The effect your distribution amount will have on the portion of your Social Security benefit that is taxed.
- Taking a lump-sum distribution may affect qualifying for state or local senior citizen programs, such as property tax rebates, prescription assistance programs, etc.
IMPORTANT NOTE: Keep in mind that if you take a lump-sum distribution (and pay the tax currently or roll it over to a traditional IRA within 60 days), you must take control of your retirement assets and maintain a certain rate of return throughout retirement.
SUGGESTION: There are two situations when taking a lump-sum and paying the tax currently may be advisable:
- If you expect income tax rates to dramatically increase in the next few years: The benefit of the lower current tax rate must be compared to the benefit of the tax-deferred accumulation of earnings under a deferral option.
- If you plan on moving to a high-tax state.
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